What are mutual funds?

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A mutual fund is an investment that allows individuals to pool their money along with other investors and invest in a collection of securities such as stocks and bonds. Most mutual funds invest in a large number of securities, allowing investors to diversify their portfolios and reduce their risk at a low cost.

While mutual funds face fierce competition for investors’ dollars in the form of exchange-traded funds (ETFs), they still remain quite popular. Here’s how mutual funds work, their pros and cons and answers to some key questions to help you decide if mutual funds make sense for you.

How mutual funds work

A mutual fund is a type of pooled investment fund in which many people own shares. Mutual funds invest in many different companies, and some even invest in the entire stock market. However, when you buy shares in a mutual fund, you don’t invest in those companies directly. Rather, you own shares in the fund, not in the companies the fund selects.

For example, imagine you invest in a tech-heavy mutual fund. That mutual fund pools the money from all its investors and invests in a number of tech companies. While the fund likely invests in companies such as Amazon and Microsoft, you don’t own shares in those companies. Instead, you simply own shares in the mutual fund.

The fund’s share price fluctuates based on the net asset value (NAV) of all of the mutual fund’s holdings. NAV is calculated by dividing the total value of a mutual fund’s assets (less liabilities) by the total number of shares outstanding. So, changes in the fund’s share price reflect the net change in all of the companies in which the fund invests.

Mutual funds solve a couple typical problems for investors:

• Mutual funds allow investors to buy a diversified portfolio without an advisor. Historically, investment advisors have tended to work mainly with those who have large amounts of money, making a well-constructed portfolio less accessible to many investors.
• Mutual funds allow investors to buy an investment portfolio quickly and at low cost, whereas maintaining a portfolio can be unrealistic for most investors to do on their own.

You can buy shares in a mutual fund from many different brokerages. Employer-sponsored retirement plans such as 401(k) plans invest primarily in mutual funds, so you may be invested in these funds without even realizing it.

Unlike ETFs, mutual funds can be traded only once per day, after the market closes at 4 p.m. eastern time. Because of this, the price of mutual funds doesn’t change throughout the day, only once the NAV settles after market close.

Types of mutual funds

Mutual funds come in a variety of forms, depending on what they invest in and how they aim to meet investors’ various goals. Here are the most common types of mutual funds.

Equity funds

Equity funds are the most popular form of mutual fund. As their name implies, these funds invest in equities, which is another name for stocks. With thousands of publicly-traded companies in the U.S., this category includes a very broad collection of stocks. Within equity funds are small-cap funds, large-cap funds, value funds, growth funds, and more.

Index funds

One of the most popular kind of fund is an index fund, which buys a preset collection of investments. Rather than try to beat the performance of the overall market, index funds aim to simply match the performance of a given index, such as the S&P 500. This strategy requires much less research and analysis than funds that attempt to beat the market, leading to lower fees for investors. Those lower fees have made these funds increasingly popular over the past decade. An index fund may own stocks, bonds, a collection of both as well as other investments.

Money market funds

Money market funds are short-term investment vehicles that usually invest in much safer securities than equity funds and index funds, things like short-term government bonds. These funds may not earn a substantial return, but investors run little risk of losing money. Many brokerages park investors’ uninvested cash in money market funds, allowing them to earn a safe return.

Fixed-income funds

Fixed-income funds, or bond funds, invest in government bonds, corporate bonds and other debt securities that pay a set rate of return. Often, they’re actively-managed and their portfolios may change frequently. Because they’re well-diversified, bond funds tend to be pretty safe, though they can be affected by moves in prevailing interest rates.

Balanced funds

Balanced funds invest in a number of different securities, including stocks, bonds and money market funds. They aim to reduce risk by providing exposure to a variety of asset classes. In some cases, these funds may have a specific asset allocation allowing investors to select investments that align with their goals.

Target-date funds

A target-date fund is a popular way to invest when you know the date you need the money, such as retirement, so they’re often found in 401(k) plans. These funds invest in higher-growth, higher-risk stocks when the target date is far off, but then gradually move to lower-return, lower-risk bonds as you near your date, making them useful for investors who don’t want to manage a portfolio.

Pros and cons of mutual funds

Mutual funds come with their share of pros and cons. Let’s take a look at both.

Pros

• They invest in a large number of securities, diversifying your investments and reducing your risk.
• They have low minimum investments compared to personal investment advisors, often no minimum, though sometimes $1,000 – $3,000.
• They are managed by professional investors.
• They are relatively liquid, and can be redeemed on any day the market is open.
• Index mutual funds are one of the cheapest ways to invest in the market, with very low expense ratios on average.
• The best funds have enviable long-term track records of growing wealth.

Cons

• While fees for some funds may be low, the expense ratios on other funds can be quite high, hindering your long-term wealth-building.
• Mutual funds lack complete transparency, meaning you won’t usually know exactly what’s in them (index funds being an exception), so you must rely on the manager’s expertise in picking investments.
• Unlike exchange-traded funds, which can be bought and sold like stock throughout the trading day, mutual funds can only be exchanged at the end of the day.
• Some mutual funds may also charge commissions – called loads – that can seriously hurt your returns, though it’s easy enough to avoid such funds.
• If the fund has a minimum investment, it’s typically much more than the cost of buying a comparable ETF, where the minimum cost is usually no more than a share.

Mutual funds and taxes

Fund managers pass on earnings to investors in the form of distributions, mainly at the end of the year. As the investor, it is your responsibility to report capital gains distributions on your tax return and pay the appropriate taxes. Even if you reinvest your dividends, you are still required to pay taxes on them since they are taxed as income.

If you are responsible for taxes when tax time comes, the fund manager should issue you IRS Form 1099-DIV. One way to reduce your tax liability is to hold mutual funds in a tax-deferred investment vehicle, such as a 401(k) or IRA.

Mutual funds vs. ETFs

ETFs often work much like mutual funds, but they have some key differences. ETFs usually track an index or other asset, and they can be bought and sold on exchanges like stocks. This allows ETFs to be traded throughout the day, and their price fluctuates accordingly. Fees are often lower for ETFs than for mutual funds, making them widely popular.

Both mutual funds and ETFs hold a selection of stocks and/or bonds, and sometimes commodities. Regardless, each type of fund invests in some kind of security or asset, and may own a similar selection of investments. In addition, both are subject to similar regulations.

However, mutual funds are typically actively managed, meaning that the fund’s managers actively analyze investments and try to beat a benchmark index such as the S&P 500. Mutual funds trade only once per day, after market close, and their fees can be high in some cases, too.

On the other hand, ETFs are passively managed, meaning the fund’s manager simply replicates the investments in a benchmark index such as the S&P 500 or Nasdaq Composite. This approach helps keep costs lower for investors, even as investors enjoy the market’s returns.

Employer-sponsored retirement plans often invest in mutual funds, while ETFs tend to be held more often by investors in an individual retirement account (IRA) or taxable account.

Who should invest in mutual funds?

Mutual funds can make sense for many investors at different points in their investing journey. If you’re just starting out, mutual funds can offer you access to a broadly diversified portfolio for a relatively low cost. Even more experienced investors can benefit from this, while also being able to choose funds that invest in a specific sector that they think is poised for growth. Funds can allow investors to pick industries that could thrive without having to pick individual winners.

Remember that mutual funds are only as good as the assets the fund invests in. If a fund invests in stocks that perform poorly, the fund will lag right along with them. Make sure you understand how a fund invests before committing any money.

If you’re investing in funds that own stocks, it’s important to be sure that you have a long time horizon. Stocks are volatile, so you’ll want to be able to hold the investment for at least three years – and five is better – to ride out any volatility and give your investment time to appreciate.

Mutual fund fees

You’ll want to watch out for the fees mutual funds may charge to avoid having them eat into your investment returns. Just a 1 percent annual fee can cost you tens of thousands of dollars over an investing career, and could cause you to fall short of your investment goals.

Mutual funds include information on their fees in the fund’s prospectus, which can be found on the investment manager’s website. It reveals the various operating expenses a fund charges, such as a management fee, which pays for the fund’s manager and investment advisor, as well as legal, accounting and other administrative fees.

You may also come across 12b-1 fees, which pay for the costs related to marketing and selling the fund. These fees are captured in a fund’s expense ratio, which shows the annual cost to own the fund as a percentage of your investment. This expense reduces your investment return each year.

You might also see something called a “load,” which is a commission paid to brokers at the time shares are purchased in the fund. The commission is usually calculated as a percentage of your total investment. Funds that don’t charge this commission are known as “no-load” funds, and there’s little reason for investors to pay this expense, since plenty of great funds don’t charge it.

Mutual fund classes

Mutual funds are sold in different share classes, with the main difference between the classes being the types of fees they charge. Here’s an overview of the key mutual fund classes. No-load mutual funds don’t charge sales loads, so they’re not included here.

Class A

Class A shares will typically come with a front-end sales load, but will have lower annual expenses, such as the 12b-1 fee, than other mutual fund classes. Some funds will lower the sales load as the amount invested increases.

Class B

Class B shares typically don’t come with a front-end sales load, but may have one on the back end, as well as a 12b-1 fee and other annual expenses. The most common type of back-end sales load is the contingent deferred sales load, which typically decreases the longer an investor holds the shares.

Class C

Class C shares can come with a sales load on either the front or back end, but it’s typically less than the amount for Class A or B shares. Unlike the B shares, the back-end load won’t decrease over time for Class C shares, which also carry higher annual expenses than A or B shares.

Class I

Class I shares will usually have lower fees than the A, B or C share classes, but are only available to institutional investors making large investments. Retail investors might be able to purchase Class I shares through an employer-sponsored retirement plan.

Clean shares

Launched in 2017, clean shares were created to increase transparency for mutual fund investors about the fees they might pay. This class of shares has no front-end sales charge, deferred sales charge or other fee related to sales or distribution of the fund. Clean shares may still come with annual operating expenses, and a broker may still charge commissions for making trades in them.

How to get started with mutual funds

Here are some steps to get started with mutual funds:

1. Research mutual funds. Many different types of mutual funds exist, including those with broad exposure (for example, to the whole stock market) and those that cover a narrower niche (such as one industry). So, you’ll want to find funds that suit your strategy.
2. Decide where to buy. The best online brokers offer mutual funds, so you’ll need to decide which one you prefer. Many now offer no-commission trading, but pay attention to the fees for each broker, if any. Calculating your mutual fund fees is also a good idea.
3. Deposit your money and buy. If you’ve already done your research, this is a simple step: just transfer money into your brokerage account and buy the shares you want.
4. Manage your portfolio. Once you’ve bought your shares, there isn’t much work to do with mutual funds. However, periodic rebalancing is a good idea if you have multiple funds.

Bottom line

A mutual fund is a type of investment consisting of stocks, bonds or other securities. The benefits of mutual funds include professional management and built-in diversification. However, mutual fund fees can be high in some cases, though the best mutual funds charge much less.